Traps to Avoid: Property Investment through your SMSF.

Residential and commercial properties owned by SMSFs are estimated to be worth more than $140 billion in total. A complying Self-Managed Superfund (SMSF) stands out as a remarkable and exclusive vehicle within the superannuation industry, offering the unique advantage of enabling members to leverage their existing balances to secure investment property purchases through borrowing.

For those who worry about their fund managers’ ability to guide their wealth-building journey effectively, and who are frustrated with losing money because of unpredictable stock market changes – or who witnessed their parents facing such losses, particularly during retirement – the concept of exploring property investment in the SMSF becomes remarkably appealing.

Before members retire and transition to the pension phase, the rental income generated by an investment property owned by the fund, after deducting tax-deductible expenses, is subject to a concessional tax rate of 15%. Moreover, any capital gain realized by a Self-Managed Superfund (SMSF) from the sale of a property – held for a minimum of 12 months – undergoes taxation at a flat 10% rate after applying the Capital Gains Tax (CGT) discount. Once you retire and activate your pension phase the funds investment income becomes tax free.

The basic rule to keep the concessional tax rate for a Self-Managed Superfund is your fund needs to be maintained for the sole purpose [1] of providing death or retirement benefits to your members or their dependents. In this article, our focus will be on highlighting actions that should be avoided within a Self-Managed Super Fund to ensure the preservation of the concessional tax rate.

Purchasing a Residential Property from a Related Party

Typically, a Self-Managed Superfund is restricted from acquiring residential property from a related party [2]. Yet, if the property qualifies as ‘business real property’—essentially a property exclusively used for business purposes by one or more entities, regardless of ownership—your SMSF can indeed purchase the property from you. This transaction, however, necessitates the fund to pay the property’s fair market value and aligns with the fund’s designated investment strategy.

A ‘related party’ of your fund comprises all members of your fund, along with associates of fund members. Associates include the relatives of each member, business partners of members, spouses or children of those business partners, and companies or trusts controlled or influenced by the member or their associates. Furthermore, the definition of a relative of a member includes parents, grandparents, siblings, uncles, aunts, nephews, nieces, lineal descendants, adopted children of the member or their spouse, and spouses of any individual specified above.

Usage of Incorrect Structure

When aiming to secure an investment property via your superfund with the aid of borrowing, the process requires the implementation of a Limited Recourse Borrowing Arrangement (LRBA )[3]This involves establishing a separate Holding Trust structure. If you’re obtaining funds from a bank, the bank ensures your adherence to purchasing regulations. This entails reviewing the deed and verifying the correctness of your overall structure for the LRBA. However, instances arise where errors emerge when members receive advice from various sources and attempt to carry out the LRBA using their own borrowed funds.

For instance, consider Chris and Jenna, who possess $1 million equity in their home. After attending a recent seminar, they learned about the option of utilizing their equity to acquire a property within their SMSF. As a result, they decided to transfer the funds into their SMSF to initiate the process.

The above example could severely impact the tax status of Chris and Jenna’s SMSF. it’s highly advisable to seek professional guidance to start the process, and before finalizing a contract for your SMSF’s property  property acquisition through the Limited Recourse Borrowing Arrangement. An incorrect contract could jeopardize the fund’s compliant status and result in additional stamp duty implications when repaying the loan and transferring the property’s beneficial interest back to the fund.

Such an error could prove to be a costly misstep. Unlike individuals or other trust structures, your SMSF is not permitted to extract equity from an existing property within the SMSF to acquire another property.

Member Use SMSF Property

Imagine Chris and Jenna from the above example taking all the right steps from the start. They sought guidance from an expert to navigate their LRBA situation and successfully purchased a gorgeous home in Byron Bay from a third party. Opting to rent it through an Airbnb management company for short-term stays, they relished in their well-made investment choice. As the school holidays approached, Chris and Jenna decide to visit Byron Bay with their children, looking forward to a family vacation and the chance to assess their investment property.

However, they encountered an unexpected challenge – all the holiday homes were already occupied by renters. In a moment of contemplation, they entertained the idea of paying the management agency to temporarily vacate the property for their stay. Yet, seemingly harmless as this notion might be, it actually violates SMSF regulations. It’s of utmost importance to avoid such scenarios to ensure strict compliance with the rules and regulations.

Your SMSF should not acquire a holiday home for your personal use, regardless of how infrequent your intent may be – even a single day’s use is not permissible. This is because the law mandates that the fund maintain a strict arm’s length relationship with its investments, ensuring they remain inaccessible to members and their associates.

Major Renovations or Developments

Properties acquired through a Limited Recourse Borrowing Arrangement require the SMSF to consistently retain the same property, thereby effectively imposing limitations on significant structural alterations. As a result, major renovations that involve complete kitchen transformations or the addition of bathrooms within the property are not allowed while the property is under LRBA arrangement[4].

In principle, you are permitted to uphold the property by attending general wear and tear (e.g., repairs and restoration to the original state). However, caution is warranted if you intend to enhance the property through improvements. Moreover, subdividing a property or knockdown rebuild within an SMSF would result in a violation, as the fund would deviate from its original single property title.

Incorrect usage of 13.22c Unit Trust

The 13.22 Unit Trust operates under a distinct set of regulations that must be adhered t  at all times, as the repercussions of non-compliance are unfavourable – as detailed below. The limitation of a 13.22C Unit Trust lies in its singular purpose – it’s designed exclusively to hold property, manage property-related financial matters, and distribute profits among its unit holders. This structure isn’t intended for accumulating funds or pursuing other investment opportunities. It doesn’t facilitate lending or creative accounting manoeuvres for early access to SMSF assets.

As stated by the SIS Regulations 1994 – Reg 13.22C [5], a SMSF is only permitted to invest in a unit trust that meets specific conditions. The unit trust must refrain from:

• Borrowing (Non-geared Unit Trust)
• Leasing to a related party, unless the asset is business real property (Commercial Property) Investing in another entity (Cannot purchase shares in a company, such as BHP)
• Lending money, except for deposits with an authorized deposit-taking institution within the meaning of the Banking Act 1959 (limited to Australian bank accounts only)
• Holding assets with charges over them (No mortgage over unit trust assets)
• Acquiring assets from a related party of the superannuation fund after 11 August 1999, except when the asset was business real property acquired at market value.
• Possessing assets that have ever been an asset of a related party of the superannuation fund since the later of:
  • The end of 11 August 1999
  • Three years before the day the SMSF first acquired an interest in the unit trust.

Arm’s Length Transaction for Commercial Property Lease

An investment in commercial property is tempting if you have a self-managed super fund (SMSF) – particularly if you run your own business. That’s because, under current regulations, your fund can buy your business premises then lease these back to your business. Essentially, it’s an opportunity to become your own landlord.

Unlike the strict regulations surrounding residential property, commercial property investment offers some flexibility. When introducing a new residential property to your SMSF portfolio, careful consideration is required to avoid breaches of in-house asset and related party acquisition rules.

On the other hand, your SMSF is permitted to purchase commercial premises and lease them to a fund member for their business operations. However, this arrangement must adhere to market rates for leasing, and punctual, full rent payments are imperative. In essence, approaching each investment within your SMSF with a commercial trustee mindset is essential. All transactions should be conducted ‘at arm’s length’, ensuring they are devoid of any personal gain, influence, or even the appearance thereof. This principle safeguards the integrity of your SMSF investments and bolsters compliance with regulations.

Although the primary focus of this article is to highlight property-related traps to avoid, we cannot overlook the following points, which are often the most evident traps that people tend to overlook and take for granted when dealing with SMSFs.

Not updating the SMSF Deed

Maintaining the health of your SMSF involves a multifaceted approach that extends beyond investment decisions. Regularly updating the SMSF Trust deed stands as a crucial task, aligning the fund with the latest regulatory requirements and ensuring its operational efficiency. Likewise, the sustenance of the trustee company demands consistent attention. This encompasses timely payment of ASIC fees, diligent documentation through minutes and resolutions, and a persistent commitment to following the SMSF guidelines.

By meticulously attending to these aspects, you safeguard the structural integrity of your trustee company, fostering compliance and fortifying the foundation upon which your SMSF operates. Periodically, the auditors examine your trust deed to verify the compatibility of your investments with the clauses stipulated by the SMSF. Additionally, on an annual basis, they assess the ASIC extract to confirm the compliance of both members and trustees.

Not Lodging the Tax Return on Time

Lodging the tax return for your SMSF on time and ensuring compliance with regulations is of utmost importance for several compelling reasons.

Firstly, meeting the deadline for tax return lodgment showcases your commitment to adhering to legal obligations. This proactive approach demonstrates responsibility and helps avoid potential penalties and legal complications that may arise from non-compliance. Timely tax return submission also ensures accurate financial reporting. By adhering to the schedule, you provide an accurate snapshot of your SMSF’s financial health, aiding in informed decision-making and strategic planning for the fund’s future endeavors.

Additionally, punctual tax return lodgment preserves the SMSF’s concessional tax rates and eligibility for various tax benefits. Non-compliance could lead to higher tax liabilities, eroding the fund’s potential returns and diminishing its overall value. Maintaining compliance safeguards the SMSF’s status as a complying fund, which is essential for the fund’s continued operation and the ability to receive contributions and enjoy favorable tax treatment. Non-compliance might result in the loss of these privileges, impacting the fund’s growth and members’ retirement goals.

Action Plan for Property Investment through SMSF: Traps to Avoid

1. Understand the Basics
   o Familiarise yourself with the unique advantages of SMSF property investments,
   including concessional tax rates.
   o Ensure the fund’s primary goal is providing death or retirement benefits.
2. Avoid Purchasing from Related Parties
   o Remember: residential property cannot be acquired from a related party unless
   it qualifies as ‘business real property.’
   o Understand who qualifies as a ‘related party’ – this includes members, their
   relatives, business partners, and more.
3. Ensure Correct Structure Implementation
   o Always use a Limited Recourse Borrowing Arrangement (LRBA) when borrowing
   to purchase a property.
   o Create a separate Holding Trust structure.
   o Seek professional advice before initiating the LRBA, especially when using
   personal borrowed funds.
4. Avoid Personal Use of SMSF Property
   o Ensure you don’t use your SMSF property for personal reasons, even for a single
   day.
   o Maintain an arm’s length relationship with your investments.
5. Limit Renovations and Developments
   o Refrain from making significant structural changes to a property under an LRBA.
   o Focus on general wear and tear repairs and avoid altering the original state of
   the property.
6. Navigate the 13.22c Unit Trust Correctly
   o Strictly adhere to the rules and limitations of the 13.22C Unit Trust.
   o Ensure you understand all conditions set out in the SIS Regulations 1994 – Reg
   13.22C.
7. Maintain an Arm’s Length Transaction for Commercial Leases
   o If leasing commercial property back to your business, always ensure the
   transaction is at market rates.
   o Stay punctual with rent payments.
8. Update the SMSF Deed Regularly
   o Keep your SMSF Trust deed current and in line with the latest regulations.
   o Maintain the structural integrity of your trustee company, including the payment
   of ASIC fees and adhering to SMSF guidelines.
9. Lodge Tax Returns Promptly
   o Submit your SMSF tax return on time to maintain compliance.
   o Understand the importance of tax return lodgement for accurate financial
   reporting and to preserve the SMSF’s concessional tax rates.
10. Stay Informed and Seek Expert Advice
    o Continuously educate yourself on evolving regulations and best practices.
    o Collaborate with experienced professionals like those at Investax to ensure you
    make informed decisions aligned with your goals.

In the intricate world of SMSF property investments, navigating regulations, compliance, and strategic decisions is a complex endeavor. As the landscape continues to evolve, the importance of staying well-informed and aligned with best practices cannot be overstated. At Investax, we understand the multifaceted challenges that accompany SMSF property investments. Our team of experts is here to guide you through every step, from choosing the right investment strategies and ensuring compliance with regulations to maximizing tax benefits. With our tailored solutions and comprehensive knowledge, we aim to empower you to make well-informed decisions that align with your financial goals and aspirations.

Reference:

Sole Purpose Test/ATO
Related Parties and Relatives/ATO
Limited Recourse Borrowing/ATO
Improvements to LRTBA Assets
SUPERANNUATION INDUSTRY (SUPERVISION) REGULATIONS 1994 – REG
13.22C

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